HOW TO SURVIVE A FAILING CHAPTER 11 –
A CREDITOR'S PERSPECTIVE
By, Mark S. Indelicato, Esq.*
Introduction
The primary goal of Chapter 11 of Title 11 ("Chapter 11") of the United States Code
(the "Bankruptcy Code") is the financial rehabilitation, rather than liquidation, of a debtor's
business. Under Chapter 11, the debtor will continue to operate its business as a debtor in
possession unless a trustee is appointed to restructure the debtor's liabilities. A successful
reorganization entails the continuation of the debtor's business as a result of the confirmation
of a plan of reorganization (the "plan"). A plan may take many forms and, if successful,
results in the creation or continuation of a viable entity. Unfortunately, however, the vast
majority of Chapter 11 proceedings do not culminate in a successful reorganization. In fact, it
is becoming more and more common for Chapter 11 cases to involve the confirmation of
plans that provide for the liquidation, instead of the reorganization, of the debtor. A
liquidating Chapter 11 enables the debtor in possession to liquidate its business for the benefit
of its creditors without the additional expense of a Chapter 7 trustee.
Creditors dealing with a "DIP" should not assume that all administrative claims will be
satisfied upon confirmation because confirmation may not occur. In addition, some
Bankruptcy Courts have fashioned orders to bifurcate the bankruptcy proceeding to insure that
the estate has resources available to conduct an orderly liquidation to maximize the value of
the debtor's remaining assets. This burgeoning area of law presents new problems for
creditors' committees and trade creditors dealing with Chapter 11 debtors. In a failing Chapter
11, the creditors' committee appointed to represent the interests of creditors may become
complacent and accept whatever is offered by the debtor. A creditors' committee should be
proactive in all aspects of the Chapter 11 process in order to maximize the value of the
debtors' assets for its constituency. A creditors' committee should restrict extensions of
exclusivity and monitor any sale process to prevent the debtor and/or its management from
repressing the sale price of the debtor's assets. Trade creditors must carefully monitor the
Chapter 11 proceeding to enable them to make realistic credit decisions about the debtor's
prospects for reorganization.
The following outline addresses some of the issues creditors should be aware of in the
event they find themselves involved in a failing Chapter 11 bankruptcy case.
*
The author, a partner at Hahn & Hessen LLP, acknowledges with appreciation the assistance of Donna J. Hyman, Esq.
and Nicholas J. Cremona, Esq., associates at Hahn & Hessen LLP.
I.
Termination of Debtor's Exclusivity – May be Necessary to Conduct Sale of Assets
A.
Bankruptcy Code Section 1121(b) provides that "only the debtor may file a plan until
after 120 days after the date of the order for relief under this chapter." 11 U.S.C. §
1121(b). In addition, the debtor has an exclusive period of 180 days after the date of
the order for relief to solicit acceptances of its proposed plan of reorganization. See 11
U.S.C. § 1121(c)(3). Upon notice and a hearing, the court may increase the debtor's
exclusive periods for cause. See 11 U.S.C. § 1121(d).
B.
In the event of a failing Chapter 11 case, a creditors' committee or individual
creditor(s) may wish to sell the assets of the debtor in the context of a plan of
reorganization or pursuant to § 363 of the Bankruptcy Code. In order to file and
circulate a plan, such creditors must first seek to terminate exclusivity to the extent it
has not already expired or been terminated. The court may reduce the debtor's
exclusive periods for cause following notice and a hearing. See 11 U.S.C. § 1121(d).
(i)
A party seeking to modify the statutory periods of exclusivity "bears the
burden of establishing that the requisite cause exists." In re Gibson &
Cushman Dredging Corp., 101 B.R. 405, 409 (E.D.N.Y. 1989). It has been
observed that "the Debtor's burden gets heavier with each extension it seeks as
well as the longer the period of exclusivity lasts; and a creditor's burden to
terminate gets lighter with the passage of time." In re Dow Corning Corp., 208
B.R. 661, 664 (Bankr. E.D. Mich. 1997). However, as a practical matter, many
courts routinely extend the debtor's exclusive periods, particularly in large,
complex Chapter 11 cases, on a relatively minimal showing of cause. A
motion to shorten or terminate exclusivity is usually heavily litigated because
the debtor is not only fighting to retain the right to control its own destiny, but
also, in may instances, to retain the jobs of senior management.
(ii)
The Bankruptcy Court has discretion and "maximum flexibility" in
determining whether or not to grant a motion seeking to extend or shorten the
debtor's exclusive period. See Gibson & Cushman, 101 B.R. at 409.
(iii)
The factors a court will consider in determining whether to extend or terminate
exclusivity include the following: (a) the size and complexity of the case; (b)
whether the debtor has had sufficient, or needs more time to negotiate a plan of
reorganization; (c) whether the debtor is making good faith progress toward
reorganization; (d) whether the debtor is paying its bills as they become due;
(e) whether the debtor has a reasonable chance of filing a viable plan; (f)
whether the debtor has made progress in negotiating the terms of a plan with its
creditors; (g) the amount of time that has elapsed; (h) whether the debtor is
seeking to extend exclusivity to pressure its creditors to submit to its
reorganization demands; and (i) whether an unresolved contingency exists.
See, e.g., Dow Corning, 208 B.R. at 665. "When [a] Court is determining
whether to terminate a debtor's exclusivity, the primary consideration should be
whether or not doing so would facilitate moving the case forward. And that is
a practical call that can override a mere toting up of the factors." Id. at 670.
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C.
(iv)
"In … cases where the exclusivity periods [have been] reduced, factors such as
gross mismanagement of the debtor's operations … or acrimonious feuding
between the debtor's principals … were major obstacles to a successful
reorganization." In re Texaco, Inc., 76 B.R. 322, 327 (Bankr. S.D.N.Y. 1987).
(v)
In In re Express One Int'l, Inc., 194 B.R. 98 (Bankr. E.D. Tex. 1996), the Court
was faced with the debtor's motion to extend exclusivity and a creditor's
motion to terminate exclusivity. The creditor argued that its proposed plan
would provide a better recovery for creditors than the debtor's plan, but the
Court recognized that the creditor's "involvement in this case [was] motivated
solely by its desire to purchase [the debtor's] business." Id. at 99. The Court
went on to state that "[t]he issue to be determined … is not whether some other
plan may exist which provides greater recovery; the issue is whether [the]
debtor has been diligent in its attempts to reorganize." Id. at 101. Finding that
the debtor had been making a diligent attempt to reorganize, the Court
extended the debtor's exclusivity period. The Express One case demonstrates
that a court will not necessarily terminate a debtor's exclusive periods in which
to file and solicit acceptances to a plan of reorganization just because a
proposed sale of the debtor's assets will provide a greater recovery for creditors
than the debtor's proposed plan.
In a failing Chapter 11, the debtor's management may attempt to use exclusivity as a
shield to protect themselves from ouster by outside forces, such as the creditors'
committee or a third party interested in purchasing the debtor's business. Such a
potential purchaser may wish to replace the debtor's management with a new team or
integrate the debtor's business into its own operations. The debtor, in order to preserve
the control of existing management, may reject the offers of third parties to either
purchase the debtor's assets or fund a plan of reorganization although such offers may
be in the best interest of the debtor's estate and creditors. An active creditors'
committee can play a pivotal role in eliminating or curtailing this type of conduct by a
debtor. The creditors' committee should insist on short extensions of the exclusive
periods to insure that the debtor will not have a stranglehold on the reorganization
process. The creditors' committee might also insist on co-exclusivity with the debtor,
which would enable only the debtor and/or the creditors' committee to file a plan of
reorganization and solicit acceptances thereto. Many debtors will oppose this
arrangement because it neutralizes the debtor's bargaining leverage and gives the
committee the ability to discuss plan alternatives with third parties. The interests of
the committee and the debtor, in certain instances, will be diametrically opposed in the
plan negotiation process. While the creditors' committee will want to maximize the
value of the debtor's assets, the debtor may wish to preserve existing management or
equity to serve the interests of management. If a debtor is permitted to obtain
unfettered extensions of exclusivity, it will be able to use exclusivity as a sword to
compel its creditors to accept whatever is offered by its proposed plan. This may also
prolong the Chapter 11 proceeding, thereby increasing the likelihood of the estate
becoming administratively insolvent.
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II.
Sale of Assets Pursuant to Section 363
A.
One of the primary benefits provided by Chapter 11 is the debtor's ability to sell its
assets pursuant to Section 363 of the Bankruptcy Code. The Bankruptcy Code
authorizes the trustee or DIP to sell assets in several ways: in the ordinary course of
business pursuant to Section 363(c) without notice or a hearing; other than in the
regular course of business under Section 363(b) following notice and a hearing; or as
part of a plan of reorganization under Sections 363 and 1123(a)(5)(B) and (D).
Section 363 provides both the debtor and any potential purchaser of its assets
protections otherwise unavailable outside of bankruptcy.
B.
Standing to Sell Assets: Bankruptcy law provides one major obstacle in that only a
debtor in possession or a trustee may sell a debtor's assets pursuant to Section 363.
Although a creditors' committee has the power to act in place of the debtor in
adversary proceedings involving lien avoidance, preference actions, and fraudulent
transfers, such authority does not extend to the sale of property of the estate free and
clear of liens. See In re Calvary Temple Evangelistic Ass'n, 47 B.R. 520, 522 (Bankr.
D. Minn. 1984) ("[n]o cases have allowed a creditors committee to proceed with a sale
of property free and clear of liens under 11 U.S.C. § 363"); see also In re Dow
Corning Corp., 199 B.R. 896, 900 (Bankr. E.D. Mich. 1996) ("Although it might be in
the best interest of the estate to sell an asset, an official committee cannot usurp the
power of management (Trustee or debtor-possession) to make that choice") (citing
Calvary, 47 B.R. at 522-23 (denying motion of creditor's committee for authority to
effectuate a 363(b) sale)). This leverage gives the debtor the ability to negotiate more
favorable plan terms with its creditors' committee. In order to take control away from
the debtor, creditors may seek the appointment of a trustee under either Chapter 7 or
Chapter 11 of the Bankruptcy Code. Generally, creditors would prefer to have the
debtor's assets liquidated under Chapter 11 by existing management rather than in the
context of a Chapter 7 case or under the supervision of a Chapter 11 trustee. This is
because the conversion of a case to Chapter 7 or the appointment of a Chapter 11
trustee may have a devastating impact on the value of the assets in a failing Chapter
11. The debtor may experience even greater losses in the time it takes the trustee to
familiarize himself with all aspects of the debtor's business.
C.
(i)
The creditors' committee can neutralize the debtor's leverage by maintaining
short periods of exclusivity and attempting, at the appropriate time, to get the
debtor's consent, with the Bankruptcy Court's blessing, to market the debtor's
assets to third parties or, at the very least, be an integral part of the debtor's
efforts to liquidate its assets.
(ii)
In many instances, the debtor's management will no longer have any incentive
to maximize the value of the debtor's assets and may assign responsibility for
the liquidation to less senior officers who lack the knowledge and experience
to maximize the value of the assets.
The debtor's management owes a fiduciary duty to creditors and, therefore, must
attempt to maximize the value of the debtor's assets for the benefit and creditors.
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(i)
In order to keep management motivated to maximize the value of the estate,
the committee must remind these individuals that they are fiduciaries. See
generally, Commodity Futures Trading Comm'n v. Weintraub, 471 U.S. 343,
354-56 (1985) (noting obligations of a DIP as trustees); Gumport v. China &
Inv. Corp. (In re Intermagnetics Am., Inc.), 926 F.2d 912, 917 (9th Cir. 1991)
(stating that officers of a DIP are officers of the court and have fiduciary duties
as such); Slater v. Smith (In re Albion Disposal, Inc.), 152 B.R. 794, 813
(Bankr. W.D.N.Y. 1993) (noting debtor's management takes on heightened
fiduciary obligations in bankruptcy). The debtor's management and board of
directors are required to act in the best interest of the bankruptcy estate,
including the debtor’s creditors, equity holders, and other parties in interest.
See Intermagnetics, 926 F.2d at 917 (noting that chapter 11 debtors occupy
fiduciary role with respect to the contents of the estate); Continental Ill. Nat'l
Bank & Trust Co. v. Wooten, Ltd. ( In re Evangeline Refining Co.), 890 F.2d
1312, 1323 (5th Cir. 1989) (stating that those performing duties in the
administration of the bankruptcy estate are officers of the court). Although
prior to insolvency, officers and directors of a corporation owe no duty to
creditors, an entity's insolvency creates a fiduciary duty in favor of the debtor's
creditors. See In re Biderman Indus. U.S.A., Inc., 203 B.R. 547, 551 (Bankr.
S.D.N.Y. 1997) ("The fiduciary obligations of directors pervade bankruptcy
administration") (citation omitted); see also In re Freedom Solar Ctr., Inc., 776
F.2d 14, 18 (1st Cir. 1985); In re Office Prod. of America, Inc., 136 B.R. 983,
986 (Bankr. W.D. Tex. 1992) (finding that debtor and its management occupy
a fiduciary role vis-à-vis the estate and its constituents). As fiduciaries, the
officers and directors of a debtor in possession must refrain from activities
designed to benefit themselves rather than the debtor's estate. See In re Wilde
Horse Enterprises, Inc., 136 B.R. 830, 840 (Bankr. C.D. Cal. 1991). Having a
debtor’s management market and sell the debtor’s assets creates a fundamental
conflict, as the debtor's management may be motivated to enter into a deal that
benefits management, but is obligated to act for the benefit of the debtor's
estate and creditors.
(ii)
A diligent committee must be fully familiar with the debtor’s operating and
financial procedures to enable it to effectively compel a debtor and its
management to sell the debtor's assets, even if doing so would be against
management's self interest, when it is apparent that such a sale is necessary to
maximize value.
(iii)
In a failing Chapter 11, a debtor may attempt to use Section 363 to liquidate
appreciated assets to mask continuing losses. Thus, the committee must
carefully scrutinize all asset sales. The debtor may gamble what little value
exists for unsecured creditors in the hopes of rehabilitating its failing business.
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D.
Sale of Property of the Estate in the Ordinary Course of Business: Pursuant to Section
363(c)(1),1 unless a court rules otherwise, the trustee may sell estate property in the
ordinary course without notice or hearing. However, neither the Bankruptcy Code nor
the legislative history of Section 363 defines what constitutes a transaction within the
ordinary course of a debtor's business. See Burlington Northern Railroad Co. v. Dant
& Russell, Inc. (In re Dant & Russell, Inc.), 853 F.2d 700, 704 (9th Cir. 1988). The
courts, therefore, have delineated the following two part inquiry to determine whether
a transaction is within the ordinary course of business: (1) under the horizontal test,
courts ask whether the transaction is the type that comparable businesses in the
industry would undertake; and (2) under the vertical test, courts ask whether the
transaction is similar to those entered into by the debtor prepetition, such that, from the
vantage point of hypothetical creditors, the proposed transaction does not undermine
the creditors' reasonable expectations as to what type of transactions the DIP is likely
to be engaged in. See, e.g., In re Roth American, Inc., 975 F.2d 949, 953 (3d Cir.
1992); Committee of Asbestos-Related Litigants v. Johns-Manville Corp. (In re JohnsManville Corp.), 60 B.R. 612, 616-618 (Bankr. S.D.N.Y. 1986).
(i)
The court in In re Waterfront Co., Inc., 56 B.R. 31, 34-35 (Bankr. D. Minn.
1985) noted that some postpetition transactions, either by their quantity (e.g.,
all or substantially all of the debtor's assets) or nature (e.g., inconsistent with
transactions typical to others in the industry), are not ordinarily conducted in
the daily operation of the debtor's business, and are, therefore, extraordinary.
See, e.g., In re Thompson McKinnon Sec., Inc., 120 B.R. 301 (Bankr. S.D.N.Y.
1990) (sale of 64% of the debtor's interest plainly outside the debtor's ordinary
course); In re Fountain Bay Mining Co., 46 B.R. 122, 124 (Bankr. W.D. Va.
1985) (transaction transferring debtor's most valuable asset not in ordinary
course); In re Frank, 27 B.R. 748, 750 (Bankr. S.D. Ohio 1983) (transaction
involving more than "typical business risk" was not in ordinary course).
(ii)
Normally, a transaction is deemed to be within the ordinary course of business
if it is in accord with the debtor's prepetition practices and typically consists of
those daily operating expenses which are relatively insignificant. Requiring
court approval for every minor transaction would frustrate the purpose of
Section 3632 and the debtor's ability to reorganize and would overburden the
court. See, e.g., In re D'Lites of America, Inc., 108 B.R. 352 (Bankr. N.D. Ga.
1989); In re Metropolitan Cosmetic & Reconstructive Surgical Clinic, P.A.,
115 B.R. 185 (Bankr. D. Minn. 1990), remanded for ordinary course of
business determination, 124 B.R. 784 (D. Minn. 1990).
1
Section 363 states in pertinent part: "(1) If the business of the Debtor is authorized under Section … 1108 … and unless
the court orders otherwise, the trustee [or the debtor in possession] may enter into transactions, including the sale or lease
of property of the estate, in the ordinary course of business, without notice or hearing…" 11 U.S.C. § 363 (c)(1).
2
The purpose of Section 363 is to allow a business to continue its daily operations without the burden of obtaining court
approval or notifying creditors of minor transactions, while protecting secured creditors and others from dissipation of
estate assets. See Dant & Russell, 853 F.2d at 704; see also In re Selgar Realty Corp., 85 B.R. 235 (Bankr. E.D.N.Y.
1988).
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E.
Sale of Property of the Estate Other than in the Ordinary Course: Section 363(b)(1)
allows the Bankruptcy Court, after proper notice and a hearing, to authorize the sale of
the debtor's assets outside the ordinary course of business. See In re Coastal Cable
T.V., Inc., 24 B.R. 609, 611 (Bankr. 1st Cir. 1982), vacated on other grounds, 709 F.2d
762 (1st Cir. 1983).3
(i)
Despite the literal text of Section 363(b), no hearing is required where all
parties are given proper notice and there is no objection to the proposed sale.
See In re Northern Star Ind., Inc., 38 B.R. 1019 (E.D.N.Y. 1984). The trustee
need only give notice affording an opportunity for objection; a court order
approving the sale is not required in the absence of objection.4
(ii)
Bankruptcy Rule 6004 requires that notice of a proposed sale outside the
ordinary course be given pursuant to Rule 2002 and, if appropriate, Section
363(b)(2). Rule 2002 mandates 20 days notice to parties in interest5 of "a
proposed use, sale, or lease of property of the estate other than in the ordinary
course of business, unless the court for cause shown shortens the time or
directs another method of giving notice."6 Notice is sufficient if it provides
parties in interest with: (1) the time and place of public sale or terms and
conditions of private sale; (2) the deadline for filing objections; and (3) an
adequate description the property to be sold, used or leased.7
(iii)
Where an objection is made to a proposed sale, courts employ a variety of
approaches in deciding whether to approve the proposed disposition of assets.
See, e.g., In re Schipper, 933 F.2d 513, 515 (7th Cir. 1991) (363 sale involves
exercise of fiduciary duty and requires an "articulated business justification");
Committee of Equity Security Holders v. Lionel Corp. (In re Lionel Corp.), 722
F.2d 1063, 1071 (2d Cir. 1983) (judge passing on contested motion to sell
should "act to further the diverse interests of the debtor, creditors and equity
holders, alike"); In re Apex Oil Co., 92 B.R. 847, 866 (Bankr. E.D. Mo. 1988)
("Section 363(b)(1) mandates that the best interest of the estate be met by
requiring any sale not in the ordinary course of business be: (1) for fair and
reasonable price, and (2) in good faith"); In re Planned Sys., Inc., 82 B.R. 919,
3
The Bankruptcy Appellate Panel stated that: "[t]his power falls within the sound discretion of the trial court." Id.; see
also In re Ancor Exploration Co., 30 B.R. 802, 808 (Bankr. Okla. 1983) ("the bankruptcy court should have wide latitude
in approving even a private sale of all or substantially all of the estate assets not in the ordinary course of business under §
363(b)").
4
The notice and hearing requirement of Section 363(b) requires court review of a proposed disposition of estate property
only where there is an objection. Accordingly, where there is no objection after proper notice, a proposed disposition of
assets may be achieved without judicial review. In re Winston Inn & Restaurant Corp. v. DeMichiel (In re Winston Inn &
Restaurant Corp), 104 B.R. 589, 595 (Bankr. E.D.N.Y. 1989); In re Snyder, 74 B.R. 872, 877 (Bankr. E.D. Pa. 1987),
rev'd on other grounds, 120 B.R. 631 (E.D.N.Y. 1990).
5
In addition to those entities that have claims against the debtor, parties in interest include any entity whose pecuniary
interest might be negatively affected by the proposed sale. See Western Auto Supply Co. v. Savage Arms (In re Savage
Indus.), 43 F.3d 714 (1st Cir. 1994).
6
Fed. R. Bankr. P. 2002 (a)(2).
7
Fed. R. Bankr. P. 2002 (c)(1); (c)(2).
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923 n. 2 (Bankr. S.D. Ohio 1988) ("The proper standard for determining in the
first instance if a proposed sale should be ordered is whether such sale is in the
best interest of the estate").
F.
Sales Free and Clear of Interests of Entities Other than the Estate: Section 363(f)
permits a debtor or trustee, under specified conditions, to sell assets of the estate free
and clear of any interest. Particularly, Section 363(f) permits a sale free and clear of
interests of an entity other than the estate if (1) applicable non-bankruptcy law
authorizes such sale free and clear, see, e.g., Citicorp Homeowners Serv. v. Elliot (In
re Elliot), 94 B.R. 343 (E.D. Pa. 1988); (2) such entity consents, see, e.g., In re Cleary
Bros. Constr., 9 B.R. 40, 41 (Bankr. S.D. Fla. 1980); (3) such interest is a lien and the
property's sale price is greater than the aggregate value of all liens, see, e.g., Scherer v.
Fed. Nat'l Mortgage Ass'n (In re Terrace Chalet Apts., Ltd.), 159 B.R. 821 (Bankr.
N.D. Ill. 1993); Richardson v. Pitt County (In re Stroud Wholesale, Inc.), 47 B.R. 999,
1001-02 (E.D.N.C. 1985), aff'd mem., 983 F.2d 1057 (4th Cir. 1986); (4) such interest
is a bona fide dispute, see, e.g., Lindsey v. Cryts (In re Cox Cotton Co.), 24 B.R. 930,
938 (E.D. Ark. 1982), vacated on other grounds sub nom., Lyndsey v. Ipok, 732 F.2d
619 (8th Cir.), cert. denied, 469 U.S. 881 (1984); or (5) such entity could be lawfully
be compelled to accept a money satisfaction of such interest, see, e.g., Bank of
Wheaton v. Red Oak Farms, Inc. (In re Red Oak Farms., Inc., ) 36 B.R. 856, 858
(Bankr. W.D. Mo. 1984). Section 363(f) allows a debtor to sell assets free and clear of
liens with any such liens to attach to the proceeds of sale. This will enable a debtor to
accelerate the sale process with respect to assets encumbered by disputed liens. Upon
proper notification to affected parties, Section 363(f) may also protect a purchaser
from claims of third parties to the sold assets.
G.
Sale of All or Substantially All Assets of the Estate: In certain instances, the highest
value for a debtor’s assets can be achieved by selling substantially all of the debtor's
assets pursuant to Section 363 of the Bankruptcy Code. Since such a sale will result in
the liquidation of substantially all the debtor's assets without many of the safeguards
provided in the plan process, courts require an additional showing of cause to justify
such a sale. In In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), the Second Circuit
enunciated the circumstances under which a bankruptcy court can authorize, prior to
the acceptance of and outside of any Chapter 11 plan of reorganization, the sale of an
important asset of the debtor's estate outside of the ordinary course of business. The
Court held "that there must be some articulated business justification . . . for using,
selling, or leasing property out of the ordinary course of business before the
bankruptcy judge may order such disposition under Section 363(b)." Id. at 1070.
Accordingly, the Court adopted a rule requiring that the bankruptcy judge "expressly
find from the evidence presented before him at the hearing a good business reason to
grant such an application." Id. at 1071. Lastly, the Second Circuit furnished some
direction for bankruptcy courts:8
8
The majority of courts have adopted the Lionel standard, see, e.g., Stephens Indus., Inc. v. McClung, 789 F.2d 386, 390
(6th Cir. 1986); In re Walsh Chevrolet, Inc., 118 B.R. 99, 101-02 (Bankr. E.D. Mo. 1990); In re Channel One
Communications, Inc., 117 B.R. 493, 496 (Bankr. E.D. Mo. 1990); In re Burke Mountain Recreation, Inc., 56 B.R. 72, 73
(Bankr. D. Vt. 1985).
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In fashioning its findings, a bankruptcy judge must not blindly follow the
hue and cry of the most vocal special interest groups; rather, he should
consider all salient factors pertaining to the proceeding and, accordingly,
act to further the diverse interests of the debtor, creditors and equity
holders, alike. He might, for example, look to such relevant factors as the
proportionate value of the asset to the estate as a whole, the amount of the
elapsed time since the filing, the likelihood that a plan of reorganization
will be proposed and confirmed in the near future, the effect of the
proposed disposition on future plans of reorganization, the proceeds to be
obtained from the disposition vis-à-vis any appraisals of the property,
which of the alternatives of use, sale or lease of the proposal envisions,
and, most importantly perhaps, whether the asset is increasing or
decreasing in value. This list is not intended to be exclusive, but merely to
provide guidance to the bankruptcy judge.
H.
I.
Courts disagree on whether and under what circumstances a Chapter 11 debtor may
sell substantially all of its assets under Section 363. However, the majority of courts
permit the sale of all or substantially all the assets of a Chapter 11 debtor outside a
plan of reorganization pursuant to Section 363(b) where the facts and circumstances
warrant such a sale.
(i)
Some courts have adopted the "emergency" rule. These courts have refused to
authorize the sale of all or substantially all of the debtor's assets except in
emergency situations. See, e.g., In re White Motor Credit Corp., 14 B.R. 584
(Bankr. N.D. Ohio 1981). However, this rule has been relaxed, if not
abandoned, in favor of a "sound business purpose" test or "best interest
standard."
(ii)
Other courts have articulated a "best interest" test. See, e.g., Stephens Ind., Inc.
v. McClung, 789 F.2d 386, 390 (6th Cir. 1986); Financial Assoc. v. Loeffler (In
re Equity Funding Corp. of America), 492 F.2d 793, 794 (9th Cir. 1974), cert.
denied, 419 U.S. 964 (1974).
(iii)
Other courts adhere to the "good business reason" standard. See, e.g., In re
Lionel Corp., 722 F.2d at 1071 ("The rule we adopt requires that a judge
determining a § 363(b) application expressly find from the evidence presented
before him at the hearing a good business reason to grant such application”); In
re Chateaugay Corp., 973 F.2d 141 (2d Cir. 1992) (following the good
business reason test).
Advantages of a Sale Under a Plan of Reorganization: A sale under a plan of
reorganization is substantially more flexible than a sale pursuant to Section 363, as it
allows a purchaser more latitude to negotiate and to avail itself of protections and
safeguards unavailable outside of a plan. For example, a purchaser under a plan is
entitled to exemptions from certain securities laws and recording taxes that may be
unavailable to a Section 363 purchaser. See, e.g., In re Jacoby-Bender, Inc., 40 B.R.
10 (E.D.N.Y. 1984), aff'd, 758 F.2d 840 (2d Cir. 1985) (finding building sold pursuant
to confirmed plan exempt from state and city recordation tax). Furthermore, because
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of the comprehensive notice required for a plan and the broad discharge provisions
taking effect upon confirmation, a purchaser under a plan may be better protected from
successor liability than a purchaser in the context of a Section 363 sale.9
J.
Advantages of a Sale Outside of a Plan of Reorganization: A sale under Section 363
may be consummated more expeditiously than a sale under a plan. Under Section 363,
the approval of the sale may be accomplished at one hearing, whereas the plan process
involves extensive negotiations, court approval of a disclosure statement, solicitation
of votes and a confirmation hearing. Since Section 363 avoids the formalities of the
plan process, a Section 363 sale is considerably less expensive than a sale under a
plan. Lastly, a Section 363 sale may be approved over any objections without the need
to procure the acceptance of creditors, whereas approval of a sale under a plan is
generally dependent upon creditor acceptance10 or confirmation over the objection of
creditors pursuant to the cramdown provisions11 of the Bankruptcy Code.
K.
Break-up Fees: A creditors' committee must monitor the sale process not only to
insure that the transaction is in the best interests of the estate, but also to make sure it
is not structured in such a way as to discourage competitive bidding. A break-up fee is
“a fee paid to the potential purchaser of business assets when the transaction is not
consummated, most commonly when the seller accepts a later bid.” In re Tiara
Motorcoach Corp., 212 B.R. 133, 137 (Bankr. N.D. Ind. 1997) (quoting In re
Twenver, Inc., 149 B.R. 954, 955 (Bankr. D. Colo. 1992) (citation omitted)). Break-up
fees have arisen, both in the bankruptcy and non-bankruptcy context, in an effort to
lure potential purchasers to make an offer to purchase assets. A break-up fee is
designed to compensate a proposed purchaser for its time incurred in structuring and
negotiating the purchase. Two tests have been developed to determine whether such
economic incentives are appropriate: (1) the "business judgment" test; and (2) the
"best interest of the estate" test.
(i)
A three part business judgment test has been established to evaluate the
appropriateness of break-up fees in bankruptcy cases: "(1) is the relationship
between the parties who negotiated the break-up fee tainted by self-dealing or
manipulation; (2) does the fee hamper rather than encourage, bidding, (3) is the
amount of the fee unreasonable relative to the proposed sale price?" The
Official Committee of Subordinated Bondholders v. Integrated Resources, Inc.
(In re Integrated Resources, Inc.), 147 B.R. 650, 657 (S.D.N.Y. 1992), appeal
9
See, e.g., American Living Sys. v. Bonapfel (In re All American of Ashburn, Inc.), 56 B.R. 186, 190 (N.D. Ga. 1986)
(authorizing bankruptcy sale free and clear of successor liability), aff'd sub nom Griffin v. Bonapfel (In re All American of
Ashburn, Inc.), 805 F.2d 1515 (11th Cir. 1986); Rubinstein v. Alaska Pacific Constr. (In re New England Fish Co.), 19
B.R. 323, 328 (Bankr. W.D. Wash. 1982) (disallowing the application of successor liability where debtor's asset sale was
approved by the bankruptcy court); Forde v. Kee-Lox Mfg. Co., 437 F. Supp. 631, 633-34 (W.D.N.Y. 1977) (stating that
permitting a claim against a purchaser in bankruptcy would inhibit the ability of the of the trustee to liquidate the estate
and contravene the priority scheme of the Bankruptcy Code), aff'd on other grounds, 584 F.2d 4 (2d Cir. 1978); but see
Chicago Truck Drivers, Helpers and Warehouse Workers Union v. Tasemkin, 59 F.3d 48, 51 (7th Cir. 1995) (finding a
bankruptcy sale did not have a per se preclusive effect on the applicability of successor liability).
10
See 11 U.S.C. § 1129(a).
11
See 11 U.S.C. § 1129(b)(2)(A).
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dismissed, 3 F.3d 49 (2d Cir. 1993). The District Court unequivocally agreed
with the Bankruptcy Court that the break-up fee was economically appropriate
because it (1) attracted and retained a successful bid, (2) established a bidding
standard for other bidders, and (3) served to attract additional bidders. Id. at
662.
(ii)
The Court in In re Hupp Indus., Inc., 140 B.R. 191 (Bankr. N.D. Ohio 1992)
developed a more restrictive approach and listed a seven factor test for
determining the appropriateness of a break up fee:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Whether the fee requested correlates with the maximization of
value to the debtor's estate;
Whether the underlying negotiated agreement is an arms-length
transaction between the debtor's estate and the negotiating acquirer;
Whether the principal secured creditors and the official creditors
committee are supportive of the concession;
Whether the subject break-up fee constitutes a fair and reasonable
percentage of the proposed purchase price;
Whether the dollar amount of the break-up fee is so substantial that
it provides a "chilling effect" on other potential bidders;
The existence of available safeguards beneficial to the debtor's
estate; and
Whether there will be a substantial adverse impact upon unsecured
creditors, if such creditors oppose the break-up fee.
Id. at 194; see also In re S.N.A. Nut Co., 186 B.R. 98, 104 (Bankr. N.D. Ill. 1995)
(analyzing "whether the interests of all concerned parties are best served by such fee");
In re America West Airlines, Inc., 166 B.R. 908, 912 (Bankr. D. Ariz. 1994)
(repudiating the business judgment rule as the appropriate test and stating that the
appropriate question is whether the transaction was in the best interests of the debtor
and its creditors and equity holders).
L.
Reimbursement of Bidder's Actual Expenses Under § 503(b): Another form of
economic incentive gaining favor in bankruptcy cases is the reimbursement of a
bidder's actual expenses under Section 503(b).12 In order to recover an administrative
expense pursuant to 503(b)(3)(D), 13 the applicant must demonstrate that it made a
"substantial contribution" to the estate. See, e.g., In re Jack Winter Apparel, Inc., 119
B.R. 629, 632 (E.D. Wis. 1990). Although "substantial contribution" is not defined in
the Bankruptcy Code or in the legislative history of Section 503, case law has
established that, for an entity to recover under Section 503(b), it must demonstrate that
12
See, e.g., Hall Fin. Group, Inc. v. DP Partners Ltd. Partnership (In re DP Partners Ltd. Partnership), 106 F.3d 667,
672-73 (5th Cir. 1997); In re 995 Fifth Ave. Assoc., L.P., 96 B.R. 24 (Bankr. S.D.N.Y. 1989); but see In re S.N.A. Nut Co.,
186 B.R. at 105-106 (applying "best interests of the estate" test in the context of administrative expense analysis and
declaring that unsuccessful bidders not entitled to bring claim for administrative expense under Section 503(b)).
13
Bankruptcy Code Section 503(b)(3)(D) states that compensable administrative expenses include "the actual, necessary
expenses . . . incurred by . . . a creditor . . . in making a substantial contribution in a case under chapter . . . 11." 11 U.S.C.
§ 503(B)(3)(D).
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(1) services were rendered to benefit all parties in the case and not just the applicant;
(2) the services rendered a direct, significant, and demonstrable benefit to the estate
and the unsecured creditors; and (3) the services were not duplicative. See In re
Envirodyne Indus., Inc., 176 B.R. 815, 819 (Bankr. N.D. Ill. 1995).14
(i)
In Hall Fin. Group, Inc., v. DP Partners, Ltd. Partnership (In re DP Partners
Ltd. Partnership), 106 F.3d 667, 672-73 (5th Cir. 1997), the Fifth Circuit
expressly approved the right of an unsuccessful bidder to seek compensation
under Section 503(b). The Court, after noting the absence of a clear definition
of "substantial contribution", adhered to the ordinary, everyday meaning of the
phrase, thus stating that the term "substantial contribution" within the meaning
of Section 503(b) means a contribution that is "considerable in amount, value
or worth." Id. at 673. The court noted that, despite the need for a more
complete standard for substantial contribution:
At a minimum . . . the court should weigh the cost of the claimed fees
and expenses against the benefits conferred upon the estate which flow
directly from those actions. Benefits flowing to only a portion of the
estate or to limited classes of creditors are necessarily diminished in
weight. Finally, to aid the district and appellate courts in the review
process, bankruptcy judges should make specific and detailed findings
on the substantial contribution issue.
Id. In addition, claimants are required to show the expenses to have been
actual and necessary and any fees incurred to have been reasonable.15
III.
Bifurcation of Chapter 11 Case
A.
In In re Caldor, Inc.-NY, et al., currently pending in the United States Bankruptcy
Court for the Southern District of New York, the debtor's management decided, as a
result of the debtor's continuing losses, that the debtor could no longer continue to
operate. These losses had caused the estate to become administratively insolvent. The
debtor, as part of its plan to wind down its business operations and liquidate its assets,
requested the Court to grant a motion which, among other things, would authorize the
bifurcation of its Chapter 11 case into two distinct phases: the "operating period" and
the "wind-down period." The debtor asserted that, as a result of the public disclosure
of the possibility of administrative insolvency of its estate, no suppliers would
continue to provide goods and services to the estate, which were necessary to complete
the liquidation, for fear of not being paid unless its Chapter 11 case was so bifurcated.
Caldor had hundreds of millions of dollars of assets that needed to be liquidated in an
orderly fashion and the debtor asserted that a conversion to Chapter 7 would result in
14
"Compensation under § 503(b) must be reserved for those rare occasions when the creditor's involvement truly fosters
and enhances the administration of the estate." Envirodyne, 176 B.R. at 819.
15
Bankruptcy Code Section 503(b)(3)(D) states that compensable administrative expenses include "the actual, necessary
expenses . . . incurred by . . . a creditor . . . in making a substantial contribution in a case under chapter . . . 11." 11 U.S.C.
§ 503(B)(3)(D).
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substantial dilution of the value of the assets. The Court granted the motion over the
objections of several creditors. The possibility of such a bifurcation being granted in a
failing Chapter 11 case in the future has serious implications for administrative
creditors.
B.
16
(i)
The order granted by the Court bestowed super-priority status upon claims
arising during the wind-down period. While these claims would likely be paid
in full, administrative claims that arose during the Chapter 11 operating period
would not be paid in full. Thus, administrative creditors would not be treated
equally.
(ii)
The order also imposed an administrative stay of collection efforts with respect
to all operating period claims. Thus, administrative creditors could not seek
payment of their administrative claims. Certain creditors objected to being
deprived of their reclamation rights.16 Suppliers that shipped goods to the
debtor immediately prior to the announcement of administrative insolvency
believe that they were entitled to reclaim those goods as a result of the
administrative "insolvency" of the debtor.
Bifurcation of a Chapter 11 case into an operating period and a wind-down period so
that the claims of wind-down creditors are preferred over the claims of other
administrative creditors would appear to violate the notion that all Chapter 11
administrative claimants should be paid on a pro rata basis. There is arguably no
statutory or other authority for bestowing super-priority status upon administrative
claims that accrue during a debtor's wind-down period.
(i)
The Bankruptcy Code contemplates that “burial expenses” may be paid ahead
of other administrative expenses by converting a Chapter 11 case to a case
under Chapter 7. See 11 U.S.C. § 726.17 The priority scheme established by
the Bankruptcy Code does not contemplate a comparable bifurcation of claims
within a Chapter 11 case.
(ii)
Such relief was summarily denied by the Honorable Arthur J. Gonzalez of the
Bankruptcy Court for the Southern District of New York in ARLCO, Inc. and
HFO, Inc. f/k/a Arley Corp. and Home Fashions Outlet, Inc., Case Nos. 97-B43789 and 97-B-43790 (see Order Denying Debtors’ Application in Support of
Order Pursuant to 11 U.S.C. §§ 105 and 364(c) Granting Super-Priority
Administrative Claim Status For Goods and Services Provided from and After
October 1, 1997 and Granting Related Relief dated February 27, 1998).
See discussion of reclamation, infra.
17
The conversion of a Chapter 11 case to a Chapter 7 case, unlike the bifurcation of a Chapter 11 case, involves the
appointment of an impartial trustee who can investigate the debtor's financial affairs and determine whether the debtor's
management and/or professionals have contributed to the failure of the debtor's efforts to reorganize. Although Chapter 7
administrative expenses get paid ahead of Chapter 11 administrative claims, creditors at least have the comfort of
knowing that there is a neutral third party conducting an investigation of the debtor's affairs and overseeing the liquidation
of its assets.
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IV.
C.
The imposition of an administrative stay deprives creditors of, among other things,
their right to (a) reclaim goods pursuant to Section 546(c) of the Bankruptcy Code;
and (b) seek payment of their administrative expense claims pursuant to Bankruptcy
Code Section 503(a).
D.
In order to protect itself from the possibility of the bifurcation of a Chapter 11
proceeding and/or the imposition of an administrative stay, a creditor should monitor
the debtor's operations and financial situation as closely as practicable so as to be able
to detect any early warning signs of the failure of the debtor's reorganization attempts.
If any such warning signs exist, a creditor may wish to stop extending credit, or curtail
its extension of credit, to the debtor.
Reclamation
A.
18
Section 2-702 of the Uniform Commercial Code ("UCC")18 provides a seller with the
ability to recover goods sold on credit to an insolvent purchaser. Section 2-702 is
incorporated and modified by Bankruptcy Code Section 546(c).19 Section 546(c)
Section 2-702 of the UCC provides as follows:
2-702. Seller's Remedies on Discovery of Buyer's Insolvency.
(1) Where the seller discovers the buyer to be insolvent he may refuse delivery except for cash including
payment for all goods theretofore delivered under contract, and stop delivery under
this Article (Section 2-705).
(2) Where the seller discovers that the buyer has received goods on credit while insolvent he may
reclaim the goods upon demand made within ten days after the receipt, but if misrepresentation of
solvency has made to the particular seller in writing within three months before delivery the ten
day limitations does not apply. Except as provided in this subsection the seller may not base a
right to reclaim goods on the buyer's fraudulent or innocent misrepresentation of solvency or of
intent to pay.
(3) The seller's right to reclaim under subsection (2) is subject to the rights of a buyer in ordinary
course or other good faith purchaser under this Article (Section 2-403). Successful reclamation of
goods excludes all other remedies with respect to them.
19
Section 546(c) of the Bankruptcy Code provides as follows:
Except as provided in subsection (d) of this section, the rights and powers of a trustee under sections
544(a), 545, 547, and 549 of this title are subject to any statutory or common-law right of a seller of goods
that has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim such goods if
the debtor has received such goods while insolvent, but—
(1) such a seller may not reclaim any such goods unless such seller demands in writing reclamation of
such goods—
(A)
before 10 days after receipt of such goods by the debtor; or
(B)
if such 10-day period expires after the commencement of the case, before 20
days after receipt of such goods by the debtor; and
(2) the court may deny reclamation to a seller with such a right of reclamation that has made such a
demand only if the court—
(A)
grants the claim of such a seller priority as a claim of a kind specified in section
503(b) of this title; or
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recognizes and modifies a seller's state law reclamation rights; it does not create an
independent right of reclamation. See, e.g., In Re Victory Markets, Inc., 212 B.R. 738,
741 (Bankr. N.D.N.Y. 1997).
B.
Often, the filing of a bankruptcy petition will result in many reclamation claims being
filed against the debtor. Where the requirements of Bankruptcy Code Section 546(c)
are satisfied, the rights of a trustee or debtor in possession will be subject to the rights
of a seller with a reclamation claim against the debtor. If a seller does not satisfy all of
the requirements of Section 546(c), its only remedy will be its ability to file an
unsecured claim against the estate.
C.
The requirements for establishing a reclamation claim pursuant to Section 546(c) of
the Bankruptcy Code are as follows:20
(i)
The seller must satisfy the requirements for establishing a reclamation claim
under state law.
(ii)
The sale of goods must have been made in the ordinary course of business.
(iii)
The seller must make a written reclamation demand. The demand must clearly
indicate the seller's intent to reclaim the goods and must specifically identify
the goods to be returned.
(iv)
The goods sought to be reclaimed must be in the debtor's possession and must
be identifiable. See, e.g. In re Adventist Living Centers, Inc., 52 F.3d 159, 162
(7th Cir. 1998); Archer Daniels Midland Co. v. Charter Int’l Oil Co., 60 B.R.
854, 856 (M.D. Fla. 1986). Reclamation may not be permitted where the
goods have been incorporated into another product or have been otherwise
altered.
(v)
The debtor/buyer must have been "insolvent" at the time the goods were
received.
(a)
Under the Bankruptcy Code, "insolvent" means a "financial condition
such that the sum of such entity's debts is greater than all of such
entity's property, at a fair valuation …" 11 U.S.C. § 101(32).
(b)
Under the UCC, a person is "insolvent" if he "either has ceased to pay
his debts in the ordinary course of business or cannot pay his debts as
they become due or is insolvent within the meaning of the federal
bankruptcy law." UCC § 1-201(23).
(B)
secures such claim by a lien.
20
See, e.g. Victory Markets, 212 B.R. at 741; Graphic Prod. Corp. v. WWF Paper Corp. (In re Graphic Prod. Corp.),
176 B.R. 65, 73 (Bankr. S.D. Fla. 1994).
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(c)
(vi)
“The overwhelming weight of authority holds … that the word
insolvent as used in U.S.C. § 546(c) refers to the Bankruptcy Code
definition of insolvent … rather than the definition of insolvent in the
state statutes and the Uniform Commercial Code.” Lawrence
Pharmaceuticals, Inc. v. Best Buy Drugs, Inc. (In re Best Buy Drugs,
Inc.), 89 B.R. 997, 998 (Bankr. S.D. Fla. 1988).
The demand must be made within ten days of the debtor's receipt of the goods,
or within twenty days after receipt if the ten day period expires after the
commencement of the debtor's bankruptcy case.
D.
Bankruptcy Code Section 546(c)(2) provides alternative remedies for creditors with
reclamation claims. Instead of allowing a seller to reclaim goods, a bankruptcy court
may allow the creditor an administrative priority claim under Section 503(b) or a lien
on property of the estate. See, e.g., Griffin Retreading Co. v. Oliver Rubber Co. (In re
Griffin Retreading Co.), 795 F.2d 676, 679 (8th Cir. 1986).
E.
A seller’s reclamation rights are subject and subordinate to any pre-existing “floating”
liens on the debtor’s inventory. See, e.g., Victory Markets, 212 B.R. at 742; In re
Child World, Inc., 145 B.R. 5, 7 (Bankr. S.D.N.Y. 1992). Where goods sought to be
reclaimed are subject to a third party’s lien, the seller’s administrative claim pursuant
to Bankruptcy Code § 546(c) is limited to the residual value of the goods after
payment of any secured claims collateralized by the goods. See, e.g., Victory Markets,
212 B.R. at 743. Thus, to the extent a secured creditor takes the value of the goods
subject to the seller’s reclamation claim, the seller’s administrative claim is worthless
and may not be satisfied from other estate assets. See, e.g., Child World, 145 B.R. at
8.
F.
It is unclear whether, in the event of a failing Chapter 11 case, creditors selling to a
debtor in possession on credit possess the right to reclaim goods in accordance with
state law and Section 546(c)(2) of the Bankruptcy Code. Arguably, the administrative
insolvency of the debtor creates another period of insolvency such that a creditor
should be entitled to reclaim the goods shipped to the debtor in possession within ten
days of the administrative insolvency.
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